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How the California Courts Evaluate Liquidated Damages Clauses

When required to interpret a liquidated damages clause, California courts use a two-part test. A liquidated damage clause is a provision whereby the parties to a contract agree, in advance, on the amount of damages that one party will receive in the event of a breach. Normally, if there is a breach and then a lawsuit, the non-breaching party must prove up the damages. If the parties agree and the circumstances allow it, a liquidated damages clause can be used instead. Liquidated damage clauses are specifically deemed valid and enforceable under California law. The Civil Code, § 1671(b), for example states:

“(b) *** a provision in a contract liquidating the damages for the breach of the contract is valid unless the party seeking to invalidate the provision establishes that the provision was unreasonable under the circumstances existing at the time the contract was made.”

This statutory provision provides the basis for the two-part test used by the courts. The first prong of the test asks whether the amount chosen bears a reasonable relationship to the range of actual damages that the parties could have anticipated. If “yes,” then the clause will be enforced. If not, if the amount chosen is disproportionate to the anticipated damages, then the court will call the liquidated damages a “penalty.” Courts will not enforce a “penalty.”

The second prong of the test evaluates two components — whether the parties made a “reasonable endeavor” to estimate fair compensation if a loss were sustained after a breach of contract, and whether, at the time the contract was made, it was “impracticable or extremely difficult” for the parties to foresee what the damages would be and how those damage might be calculated. In order to satisfy the “reasonable endeavor” requirement, courts require evidence that the party seeking to enforce a liquidated damages clause actually engaged in some form of analysis at the time of the making of the contract. Nothing too elaborate is required. But the parties must have engaged in some genuine and non-pretextual effort to estimate a fair compensation for the potential losses. Part of that evaluation must have shown that there was no easy method of calculating the losses in the event of a breach.

A case that illustrates these principles is Jiu Zhou Group (HK) Holding Ltd., v. M. Brothers, Inc., Case No. B269861, c/w No. B272470 (Cal. App. 2nd Dist. June 30, 2017) (unpublished).

That case involved an agreement for the marketing of LCD and LED televisions signed in 2011. The agreement contained a liquidated damages clause for $1 million. At the trial level, the clause was enforced under this two-part test. First, the trial court noted that the agreement was for three years. Second, the court noted that market projections were uncertain, but the forecast predicted a potentially high-side estimate of $250,000,000 in potential sales of the LCD and LED televisions. Given these factors, the trial court held that anticipated damages were sufficiently uncertain at the time the contract was made and that the amount was a reasonable as a rough approximate. The trial court was affirmed by the Court of Appeals.

Contact San Diego Corporate Law

For more information, contact attorney Michael Leonard, Esq. at San Diego Corporate Law. Mr. Leonard has the experience to draft your contracts properly and can provide advice and counsel with respect to the proper use of liquidated damages clauses. Mr. Leonard has been named a “Rising Star” four years running by and “Best of the Bar” by the San Diego Business Journal. Contact Mr. Leonard by email or by calling (858) 483-9200. Like us on Facebook.

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